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Tax Breaks and a Low P/E Compared to Industry Could Propel Embraer Stock Price in Second Half of 2012

June 04, 2012 | About:
Airlines around the world are sad­dled with obsolete, fuel-hog­ging aircraft, an increasingly unten­able burden because of the high cost of oil. New aircraft on the market are not only more fuel efficient, but their lightweight composite structures also lower maintenance costs.

According to the International Air Transport Association (IATA), glob­al airlines will invest $3.5 trillion to buy 27,800 new airplanes over the next two decades. Although the world economy remains shaky, booming passenger traffic in emerging markets is boosting demand for new airplanes, especially smaller jet aircraft. The two main classes of small aircraft are re­gional jets, defined as having a capac­ity of 30 to 120 seats, and business jets (bizjets), defined as anything smaller.

Manufacturers of smaller, fuel-efficient aircraft will tap into huge, long-term demand, as increasingly affluent consumers in emerging mar­kets join the middle class and be­come airline passengers.

The aviation standard for measur­ing commercial air travel volume is revenue passenger miles (RPM). An RPM represents one paying passenger traveling one mile. According to the US Federal Aviation Administration, RPMs will nearly double over the next two decades, from 815 billion in 2011 to 1.57 trillion in 2032, with an aver­age increase of 3.2 percent per year.

One-third of the demand for new aircraft over the next 20 years will come from Asia, which now accounts for 28 percent of global air passengers. Much of this demand will be for re­gional aircraft, a niche largely ignored by the two largest aircraft manufactur­ers: Boeing (BA) and Airbus, a subsidiary of the European Aeronau­tic Defence and Space Company, or EADS (EADS).

Emerging nations also need to build international and intercity transporta­tion hubs. China alone has 40 new airports on the drawing boards. The major beneficiaries of this infrastructure spend­ing will be low-cost air carriers, which are buying smaller planes with an eye on controlling fuel consumption.

The best way to play this long-term aerospace cycle is to invest in the mak­ers of the planes, rather than the airlines themselves. Below, I look at one particular­ly innovative manufacturing company that is challenging the Boeing-Airbus manufacturing duopoly.

The company is going head-to-head against larger counterparts by filling niches that the behemoths have largely aban­doned. The company is also leveraging lower-cost labor and supply chains in devel­oping countries.

Embraer (ERJ), based in Brazil, manufactures aircraft that are sleek, “green” and easier to main­tain than Boeing and Airbus models. Moreover, its home country of Brazil is one of the fastest growing aviation hubs in the world and provides steady local demand for its aircraft.

Founded in 1969, Embraer is a rela­tive newcomer to the aerospace sec­tor but it has made enormous inroads. The company now is the world’s third-largest commercial aircraft maker and dominates the market for regional jets.

The company’s commercial avia­tion segment, which produces region­al jets, accounted for 65.7 percent of revenue; business jets contributed 13.1 percent; defense 20.1 percent; and others 1.1 percent.

Embraer’s future prospects look se­cure: The company reported an order backlog for fiscal 2012 of nearly $15 billion, equivalent to three years of projected annual revenue. The com­pany is especially sanguine about its prospects in the Middle East, where it expects to sell $14 billion worth of aircraft from now to 2030.

Despite these long-term advantages, shares of Embraer trade at a relative bargain, after a first-quarter 2012 earnings reported on April 26 missed ana­lyst projections.

Embraer reported that first-quarter profit dropped to $62.7 million from $105.1 million a year earlier, falling short of the consensus estimate of $79 million. However, this disappoint­ment largely resulted from a heavier tax burden and rising labor costs in its home country, two temporary factors that Embraer already has rectified this year through negotiations with the Brazilian government.

As part of Brazil’s newly enacted busi­ness stimulus package, Embraer will see its payroll tax burden reduced to zero starting in the second half of 2012, giv­ing it a gain of about $97 million in profit this year and improving its net margin by 1.7 percentage points.

Meanwhile, the company’s un­derlying business remains strong. Throughout the first quarter of 2012, Embraer delivered 34 com­mercial jets, compared to 28 during the same period in 2011. Increased aircraft deliveries, coupled with rev­enues from aviation services and the company’s growing defense seg­ment, boosted first-quarter revenues to $1.15 million — up 9.5 percent year over year. The company continues to dominate orders for regional jets, particularly in fast-growing emerging markets, positioning it to gain the most from an accelerating recov­ery in these countries. Embraer this year opened a new office in Dubai and is expanding customer support throughout the Pacific Rim nations and the Middle East.

China is among the biggest emerg­ing markets for regional jet makers. Embraer estimates that China-based airlines will order 975 jets in the re­gional jet category from now until 2030. Embraer already commands a 70 percent market share for regional jets in the Middle Kingdom.

Embraer’s P/E ratio of 54.4 makes the stock a solid value investment, considering the compa­ny’s growth prospects and the average aerospace industry P/E of 85.5.

About the author:

John Persinos
Investing Daily provides stock market advice and investment newsletters to help independent investors achieve a secure and rewarding financial future. The site’s coverage focuses on finding the most profitable emerging trends in the investment universe to bring investors pragmatic and in-depth coverage of the names that are taking advantage of these opportunities.

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